Sunday, 19 April 2009

Large number fatigue is setting in and it is beginning to give rise to intellectual complacency and misleading rhetoric.

We need to distinguish between different ways of thinking about scary numbers.

The first kind occurs in articles and commentary where it is claimed that so many trillions of dollars have been wiped off the stock market, real estate market or national wealth. In fact in the current circumstances, after a few weeks of rallying in equities, it is not uncommon to see talk of supposed massive increases in our wealth, for example in an article entitled The Seven Trillion Dollar Rally .

The fallacy with both the bad and good news in this regard - the trillions that have allegedly disappeared or are now reappearing in asset values - is that the valuation of the whole market, in the case of the above article it is specifically the US stock market, is being made by determining an aggregate value by extrapolating from the current pricing at the margin.

To make it simple and concrete, the last price on say the S&P 500 is being used to determine the market capitalization of those entire 500 large enterprises. This really makes little sense as the number is erratic and does not reflect anything other than a snapshot in the trading history of the financial instruments and not the underlying value of the companies. One is not talking about a liquidation value for these companies or for the market as a whole. Thinking about this for one moment it makes no sense even to talk about the liquidation value of the entire S&P 500. If everyone was looking to sell there is an obvious problem which can highlighted by asking the simple question - to whom would they be selling?

Can the same argument be made about the value of the legacy assets - CDO's, CMO's, RMBS's etc. - that are on bank's balance sheets? My suggestion is that the marginal liquidity of these assets, i.e. what they would command in the market place at any moment in time, is far more critical in that the nature of banking and creditworthiness depends upon the perception of confidence at the margin. Why do I say that? Because confidence is either all or nothing in the case of banks. If one was to be told that Bank A had less liquidity and more questionable assets on its books than Bank B which bank would you rather do business with? If all banks are considered to be even slightly suspect then the whole banking system could crash. And that's what very nearly happened last October.

The third kind of scary numbers have to do with the state of the public finances and the debts that are accumulating on the balance sheets of many sovereign borrowers. Leave aside the guarantees that have been put in place for possible losses on legacy assets, and just consider the massive deficits that say the US and UK governments are facing (spelled out numerically elsewhere and with much greater precision than I am focused on in this piece). These kinds of scary numbers, in terms of annual operating deficits (now in the region of 12-15% of GDP) and the accumulating national debt (at least 100% of GDP) are truly scary numbers. And they are real - they are not based on any fallacy of valuing the national debt at some hypothetical margin. These are actual obligations and incurred expenditures that have either already been paid out or must be paid out in the future.

Two things in particular make them worthy of any citizen's or investor's top of the mind attention.

Firstly, how much debt service will be have to be paid on these debts? This, of course, raises the awkward issue of what is the interest rate environment going to look like in the future? To which an even more awkward question needs to be asked - to what extent are governments planning to inflate their way out of their public finance crises?

Needless to say this issue has a vicious circularity to it.

Secondly, is their the will and discipline to really address the pay-down and prudent management of these mountains of debt by the political and financial elite?